Many people completely ignore open interest (- in futures & options market) data in stocks, believing it to be totally irrelevant for someone who trades in the cash segment. No wonder then, that most short term investors, even those who trade in the cash market suffer losses.

One of my favorite quotes – “It takes considerable knowledge just to realize the extent of your own ignorance”.

If you buy and hold shares as a long term investor then may be you do not need to worry about what happens in the F&O markets. But if you trade in the cash market (both intraday or with a short term time horizon) then open interest data is as relevant to you as it may be for someone trading option or future contracts.

I have heard all sorts of explanations in this area so I will tell you what it is not first:

What is ‘NOT’ Open Interest

• It is not the total volume of contracts traded a given day, month or week.
• It is not the monetary value of those contracts at the current market price of the share – I even heard someone come up with a weighted average formula across 10 different strike prices to arrive at some vague equilibrium price for the stock.
• It is not the aggregate of open positions across futures and calls and puts, and definitely no netting or squaring off happens in any calculation.
• Open Interest is different across futures and options markets (and further across option lots at different strike prices) and there is no way to come up with standard open interest equilibrium of any kind – more on this below.
• It has nothing to do with any disclosure requirements.

Open Interest: Meaning

Open interest is the total number of outstanding contract lots that are held by market participants at any point in time.

The total number of outstanding contracts will naturally differ across futures and options markets. Accordingly, you should consider these as 3 separate markets for the purpose of calculating open interest.

Put differently, contracts lots could be lots in futures or options (calls & puts). There is no netting off between the open interest in call options and put options. Further, open interest in a call option at a given strike price has nothing to do with the open interest created in the same call option at a different strike price.

As underlined above, open interest is the total number of outstanding contracts and not the total value of the outstanding contracts. Further, it should be differentiated from the concept of a contract’s trading volume. The below example will clarify this.

Unlike total volume, open interest will drop if a contract is liquidated.

• Open interest will increase by 1 contract when a buyer enters a new long position while the seller is entering a new short position.
• Open interest will decrease by 1 contract if a buyer is closing an old short position and the seller is closing an old long position.

And open interest will stay the same if:

• A buyer is entering a new long position while the seller at the same time is closing an old one
• A seller is entering into a new short position but the buyer is simultaneously closing an old position.
  

Relevance of Open Interest Data – What does it indicate?

1. Open interest highlights the total number of option contracts that are currently open, i.e. contracts which have been traded but not yet liquidated by an offsetting trade.

Example: On 17 July 2014, the data for NHPC’s call option expiring on 31 July 2014 with a strike price of Rs. 22.50 shows 2, 76,000 call option contracts as open.

Does this number refer to options bought or sold? Since there is 1 bought position and 1 sold position for each of these contracts, there are 276,000 bought positions and 276,000 sold.

2. Open interest is a good indicator of the liquidity in the contract. Putting it simply, open interest is a measure of how much interest is there in the option or future contracts of a particular underlying stock/ index. Increasing open interest indicates that that fresh money is flowing into the stock /index. To that extent, higher open interest means – higher activity and interest in the particular option or future. Remember: This does not mean that the underlying stock /index will necessarily rise in future. It just highlights heightened interest which could point to a bearish or a bullish future trend. If traders are bearish i.e. they believe that the stock /index price will fall, they may buy put options or sell call options at a particular strike price, typically below the current market price.
3. Open Interest as a tool to forecast the future price movement of the stock: One of the big benefits of monitoring open interest data is that it could give valuable guidance about the future price of the underlying stock. How?

Typically, if the open interest at a certain strike price increases and such strike price is above the current spot market price of the stock, it indicates a rising trend in the stock, provided that the price of the stock is also increasing at the same time.

Why?

Typically, call buyers hope that the stock price will continue to rise and hence they buy ‘out of money call options’, thus creating a build up at a strike price above the spot price. Similarly a buildup in open interest at a price below the spot price, coupled with a falling stock price, is led by those who buy put options or write call options.

But there are many different strike prices?

Typically, look at the strike price where buildup is the highest and check if that strike price is above or below the current spot price of the share.

What about Futures, where there is no strike price?

Just like option lots, future lots expire on the last Thursday of each month but there are no strike prices here. Future contracts are marked to the market price at the close of every trading session and finally settle on expiry. However, if the premium between the future price and the spot market price increases beyond a reasonable level, it may indicate that most investors are turning bullish on the future prospects of the underlying stock /index (i.e. they are willing to buy the future lots at a price much higher than the current market price and are hoping that the price in future will rise). Of course this has to be coupled with an increase in the open interest in future market.

By monitoring open interest at the end of each trading day, you can draw the following conclusions:

1. If prices are rising and open interest is also increasing, it indicates that the upward price movement could continue.
2. If prices are rising and open interest is decreasing, it indicates that the upward price movement may be about to reverse
3. Open interest is also used to determine the market activity – Increasing open interest indicates higher trades, which indicates that the market is being actively traded and vice versa.

The relationship between the prevailing price trend and open interest is summarized in the following table:

Again, there is no thumb rule and it is not that this is how the markets will always behave. If that were the case, no one would ever lose money in stocks. Unfortunately, for 1 winner there has to be 1 looser in any form of trading, stocks trading follows this principle equally well. The point to take away is that open interest has an impact across both, cash and derivative markets, a point often overlooked by those who do not trade futures and options.

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Rajat Sharma

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